Buying Gamma in Low Vol Environments

An environment of persistent low volatility in 2016 has made conditions for selling options premium somewhat challenging.

Aside from January and February, when oil was tanking, the VIX has hovered in the low-teens - well below its historical average of about 19.

Looking at the state of the S&P 500, the Dow Jones Industrial Average, and the Nasdaq (at or near all-time highs), it's no great surprise to see compressed levels in the VIX. The direction of stocks and the VIX are inversely correlated - as one goes up, the other goes down - and vice versa.

Given the current environment, the tastytrade team has been looking at the historical success rate of long premium strategies, particularly when overall volatility is on the lower end of the spectrum.

Those who already follow the tastytrade financial network will be well aware of research we've conducted that relates to active management of winners/losers and expiring positions.

A recent episode of Market Measures took a closer look at the latter subject - expiring positions.

As options get closer to their expiration date, they become less impacted by volatility and more impacted by "gamma” (i.e. absolute breakeven). The reason for this is due to the shortened time frame of such contracts. With a week, or just a couple days left in their life, stocks making big moves don't have time to "revert" back to their mean. That's why we think of these positions as "gamma," instead of “volatility.”

For comparison purposes, consider an option with six months to expiration versus an option with only a week to expiration. The underlying in this example is trading $81 and you are short the $80 put (both in the near term option and the long-term option). If stock drops below $80 during the week of expiration, a trader short the $80 put won't have time for the stock to retrace back above strike (potentially back to its mean), whereas the trader short the $80 put six months out will have more time to see if the stock does rally back.

Given the risk profile of gamma (options expiring in days not weeks/months), and the current absolute low levels in the VIX, the Market Measures team conducted a study that examined whether buying gamma (as opposed to selling it) during these periods could produce consistent, attractive returns.

Using data from 2005 to present in the SPY and GLD, the study backtested buying straddles with 10 days-to-expiration (DTE) and 5 days-to-expiration to analyze the profitability of this approach. The study looked at all instances over that timeframe as well as only the instances in which IVR in the underlying symbols was below 25.

As you can see in the slide below, the success rate (percent profitable) and the median profit/loss of the scenarios examined were not attractive on a stand-alone basis:

While the results shown above indicate that this approach might not be profitable in a vacuum, it's entirely possible that long gamma positions may fit your portfolio under certain circumstances, or according to your own unique strategy.

We encourage you to watch the entire episode of Market Measures focusing on long gamma when your schedule allows.

If you have any questions or comments on the topics discussed in this post don't hesitate to reach out at support@tastytrade.com.

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.

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